Method and system for managing financial instruments based on playing a game

ABSTRACT

A method and a system is disclosed for creating and managing financial instruments, which may be designed to increase the risk-adjusted return of investment portfolios and other collections of assets and/or liabilities. A computer may be used to access databases containing asset information, liability information, counterparty information, metric information, and swap agreement information. Swap information may be received including first counterparty information and first metric information comprising a future cash flow that is at least partially determined by one or more events associated with playing one or more games. A first swap agreement may then be executed. A metric value for the first metric information may be determined and cashflows value to be paid and/or received may be calculated. The calculated cashflows value may be exchanged.

CROSS-REFERENCE TO RELATED APPLICATIONS

This application is a continuation of U.S. patent application Ser. No.11/367,838, filed Mar. 4, 2006, which claims benefit to the filing datesof U.S. Provisional Patent Application Ser. No. 60/698,216, filed Jul.11, 2005, U.S. Provisional Patent Application Ser. No. 60/669,607, filedApr. 9, 2005, and U.S. Provisional Patent Application Ser. No.60/659,035, filed Mar. 5, 2005. The contents of each of the applicationsare incorporated herein by reference in their entirety.

U.S. patent application Ser. No. 11/367,838 is a continuation-in-part ofU.S. patent application Ser. No. 10/733,482, filed Dec. 11, 2003, whichapplication claims benefit to the filing date of U.S. Provisional PatentApplication Ser. No. 60/432,851, filed Dec. 12, 2002. The contents ofeach of the applications are incorporated herein by reference in theirentirety.

U.S. patent application Ser. No. 11/367,838 is also acontinuation-in-part of U.S. patent application Ser. No. 10/043,071, nowU.S. Pat. No. 7,407,436, filed Jan. 8, 2002, issued Aug. 5, 2008, whichapplication claims benefit to the filing date of U.S. Provisional PatentApplication Ser. No. 60/260,547, filed Jan. 8, 2001, and which alsoclaims benefit to the filing date of U.S. Provisional Patent ApplicationSer. No. 60/260,546, filed Jan. 8, 2001. The contents of each of theapplications are incorporated herein by reference in their entirety.

FIELD OF INVENTION

A method and system is disclosed for creating and managing DiversativeFinancial Instruments. Diversative Financial Instruments are designed toincrease the risk-adjusted return of investment portfolios and othercollections of assets and/or liabilities.

BACKGROUND OF THE INVENTION

One of the principal reasons for investing in alternative assets is theexpectation of “uncorrelated returns”, i.e., returns that are at mostweakly correlated with traditional asset classes such as stocks andbonds. Hedge funds, private equity, real estate, and other vehicles havebeen offered as providers of uncorrelated returns. Many of theseinvestments do offer uncorrelated returns much of the time. Nonetheless,a significant unsolved problem remains: the lack of correlation tends tobreak down when it is most needed, i.e., in times of market crisis.

For example, a Fund of Hedge Funds (“FoHF”) may see its constituentfunds' correlations to standard benchmarks jump from around zero toaround one. Worse, the beta of these funds (whose financial andoperational leverage may be significant) can increase even more, leadingto losses that are a multiple of what is happening to the benchmarks.And we have not yet considered the impact of borrowing at the FoHFlevel.

This problem, which we will refer to as the “Regime Switching Effect”,threatens to negate one of the major reasons for investing inalternatives. (The other reason, the desire to capture alpha, is alsoaffected by the Regime Switching Effect.)

U.S. patent application Ser. No. 10/043,071, filed Jan. 8, 2002discloses a method and system for creating financial instruments(“SCOREs”) whose future cash flows are at least partially determined byan event or events associated with playing of one or more games or inrelationship to an event or events that can be modeled in game-theoreticterms.

For example, a SCORE bond could have weekly interest payments that arelinked to whether or not a particular state lottery has a grand-prizewinner that week. If there is a winner, bondholders forgo one or moreinterest payments according to a predefined schedule. When there is nowinner, bondholders collect interest payments large enough to compensatefor the risk of periodic missed payments.

An alternative mechanism would be to eliminate the bond entirely and tocreate a SCORE derivatives contract (funded or unfunded) with abi-directional cash flow structure. In this instance, an investor orinvestors would receive periodic payments from a counterparty inexchange for guaranteeing a prize payment. In a preferred embodiment,the investor(s) would receive many small payments in exchange for makingan occasional large payment. They would provide game operators (e.g.casino or state lottery) the ability to offer much larger prizes byaccepting regular premia from the game operators.

SCORES are a new class of financial instruments that offer a means forproducing sustainable uncorrelated returns. “SCORE” is an acronym for“Securities Collateralized by the Outcome of Random Events.” SCOREs maybe implemented in a variety of ways, including as fixed incomesecurities, equity securities, and OTC derivatives subject to ISDA-likerules.

Unlike existing alternative assets, SCOREs derive a portion of theirreturns from a random process associated with the playing of a game suchas the outcome of a state lottery. For example, a SCOREs contract may bewritten to allow a state or national lottery to offer a super-grandprize, providing a powerful inducement for players to buy tickets.

Given that their returns are at least partially independent of marketforces, SCOREs may be used to provide portfolio diversification evenwhen the Regime Switching Effect destabilizes other alternative assets.

DETAILED EXAMPLES OF SCOREs IN OPERATION Example 1 Large State Lottery

State Lottery “A” currently sells $1,000,000,000 worth of tickets overtwo years.

-   -   $500,000,000 gets returned to players as prizes. Over the course        of two years, $300,000,000 is paid out in 50 grand prizes        ranging from $2,000,000 to $10,000,000 with an average value of        $6,000,000. The remaining $200,000,000 is paid out in small        prizes.    -   $400,000,000 goes into the state's education fund.    -   $100,000,000 covers costs.

The state has severe budget difficulties and needs to double itslottery-based education funding. It decides to do this by embedding asuper-grand-prize, which pays out on average once in 100 weeklydrawings, into its existing lottery. To accomplish this, “A” enters intoa SCOREs contract with a counterparty consisting of a group of financialinstitutions and/or institutional investors. “A” pays a premium of$1,000,000 per week to the counterparty. The counterparty guarantees asuper-grand prize with an NPV of $40,000,000, expecting to pay it oncein two years. The state advertises a $100,000,000 (nominal) super-grandprize, enabling it to double ticket sales over two years.

Result:

State Lottery “A+SCOREs” sells $2,000,000,000 worth of tickets over twoyears.

-   -   $940,000,000 gets returned to players as prizes. Over the course        of two years, $540,000,000 of this prize money is paid out in 90        grand prizes ranging from $2,000,000 to $10,000,000 with an        average value of $6,000,000. $360,000,000 is paid out in small        prizes. A single super grand prize of $40,000,000 is paid.    -   $800,000,000 goes into the state's education fund.    -   $300,000,000 covers costs, including $100,000,000 paid to the        counterparty.

Analysis

-   -   Lottery doubles its take, while increasing its net cost by 3        cents per dollar ticket.    -   Players win nearly twice as many prizes, with a super-grand        prize as inducement to play.    -   Investors earn an expected P&L of $60,000,000 over two years. In        return, investors bear the risk of loss in 8% of two-year        intervals. Evaluated against a nominal capital reserve of        $100,000,000, expected IRR is approximately 30%. See Table One.

Example 2 National or Multi-State Lottery

National or Multi-State Lottery “M” currently sells $10,000,000,000worth of tickets over two years.

-   -   $5,000,000,000 gets returned to players as prizes. Over the        course of two years, 3,000,000,000 is paid out in 50 grand        prizes ranging from $20,000,000 to $100,000,000 with an average        value of $60,000,000. The remaining $2,000,000,000 is paid out        in small prizes.    -   $4,000,000,000 goes into the national or multi-state fund.    -   $1,000,000,000 covers costs.

The government entity has severe budget difficulties and needs to doubleits lottery-based funding. It decides to do this by embedding asuper-grand-prize, which pays out on average once in 100 weeklydrawings, into its existing lottery. To accomplish this, “M” enters intoa SCOREs contract with a counterparty consisting of a group of financialinstitutions and/or institutional investors. “M” pays a premium of$10,000,000 per week to the counterparty. The counterparty guarantees asuper-grand prize with an NPV of $400,000,000, expecting to pay it oncein two years. The governmental entity advertises a $1,000,000,000(nominal) super-grand prize, enabling it to double ticket sales over twoyears.

Result:

Lottery “M+SCOREs” sells $20,000,000,000 worth of tickets over twoyears.

-   -   $9,400,000,000 gets returned to players as prizes. Over the        course of two years, $5,400,000,000 of this prize money is paid        out in 90 grand prizes ranging from $20,000,000 to $100,000,000        with an average value of $60,000,000. $3,600,000,000 is paid out        in small prizes. A single super grand prize of $400,000,000 is        paid.    -   $8,000,000,000 goes into the government fund.    -   $3,000,000,000 covers costs, including $1,000,000,000 paid to        the counterparty.

Analysis

-   -   Lottery doubles its take, while increasing its net cost by 3        cents per dollar ticket.    -   Players win nearly twice as many prizes, with a super-grand        prize as inducement to play.    -   Investors earn an expected P&L of $600,000,000 over two years.        In return, investors bear the risk of loss in 8% of two-year        intervals. Evaluated against a nominal capital reserve of        $1,000,000,000, expected IRR is approximately 30%. See Table        One.        A Matter of Scale

Comparing Examples 1 & 2, it is obvious that the latter is equivalent tothe former with a tenfold increase in the numbers. An interestingquestion arises: how scaleable are SCOREs? How will ticket sales—thesource of revenue for government lottery and institutional prizeguarantor—respond to larger and larger prizes? While no one can know theanswer with certainty, it is a given of the lottery industry that bigprizes=big sales. The effect is non-linear, i.e., bigger prizes are moreprofitable than smaller prizes. Hence, if anything, billion-dollarlotteries, properly organized and marketed to the public, should sellmore than enough tickets to justify the effort. Aside from creating agroup of new centimillionaires, SCOREs would deliver much neededdiversification to portfolios currently at risk from the RegimeSwitching Effect.

Assuming that SCOREs are worthwhile investments, how large a marketcould be created for them? What of the downside from promoting gambling?

Taking the second question first, it is important to note that SCOREswere invented in conjunction with a new type of lottery called Nu Lots™.Nu Lots converts standard lotteries (and other games) into automaticsavings/investment vehicles by taking a portion of each player'sconsideration (e.g., cost of a ticket) and instead of putting it at riskin the game, depositing it into a savings or investment account forlong-term appreciation. Nu Lots offers the prospect of transforming thelottery and broader gaming industries, by embedding automaticsaving/investment vehicles in all sorts of games. Nu Lots players wouldstand to gain significantly more from their automatic savings than theywould put at risk by playing lotteries or other games of chance.

Now, returning to the first question, even without Nu Lots, a very largemarket exists for securitizing gambling risk. Current global gamblingrevenues exceed $150 billion per year, with $50 billion in lotteriesalone. Securitization of gambling risk could help create a significantlylarger industry, by allowing game operators to hedge their risk moreeffectively and for larger prizes. Securitization, if used to createportfolios that perform better in market crises, would offset potentialnegative consequences from increased gambling. Finally, if Nu Lots stylegames become the norm for the industry, the effects would be absolutelytransformative. People who save and invest nothing would becomeautomatic captalists, without having to give up their dreams of a bigwin. Games would emerge that even hardened rationalists would decidewere worth playing, as the cost of positive skew became more reasonable.

TABLE ONE Return to SCOREs Investor as a Function of Number ofSuper-Grand Prize Winners (on Notional $100 M) # of lottery returnnotional drawings wins prob (millions) exp ret return exp P&L 100 036.60%   100 36.60323   100% $36,603,234.13 100 1 36.97%    60 22.18378   60% $22,183,778.26 100 2 18.49%    20 3.697296    20% $3,697,296.38100 3 6.10%  −20 −1.219983  −20% ($1,219,983.32) 100 4 1.49%  −60−0.896503  −60% ($896,502.89) 100 5 0.29% −100 −0.289779 −100%($289,778.71) Scenario $60,078,043.84 Weighted P&L:

In the above table, it can be seen that in more than 9 of 10 two yearintervals, SCOREs are expected to return a positive gross P&L between20% and 100%. The most likely loss scenario, in which 3 super-grandprizes are awarded during the two-year life of the contract, would beexpected to happen to a given lottery less than once in 30 years. Fouror more super grand-prize wins in a two-year period would be expectedless than once in 100 years.

NOTE:

It is possible to transfer risk of loss by creating tranched SCOREs.Development of a market in collateralized Gaming Obligations™ (CGOs™)should facilitate the creation of liquid market for SCOREs. Looking backat Table One, tranching of SCOREs would sub-divide risk and returnamongst investors holding the tranched securities. For Example, twoinvestors could divide the risk/return distribution as follows:

Investor A retains the risk of 1 or 2 super-grand prize payouts over theterm of the contract, transferring the risk the 3^(rd) or any highernumber of payouts to Investor B. Investor B receives a portion (say 20%)of Investor A's premium, in consideration of the risk he is accepting.In this way, Investor A largely eliminates his risk of loss, while stillearning a very nice return. Meanwhile, Investor B earns a very nicereturn by accepting the possibility of a significant loss that would notbe expected to happen more than once in 30 years of play.

Alternatively, Investor A could retain the risk of up to 3 super-grandprize payouts over the term of the contract, transferring the risk the4^(th) or any higher number of payouts to Investor B. Investor Breceives a portion (say 10%) of Investor A's premium, in considerationof the risk he is accepting. In this way, Investor A limits hispotential losses substantially, while still earning a very nice return.Meanwhile, Investor B earns a very nice return by accepting thepossibility of a significant loss that would not be expected to happeneven once in a hundred years of play.

Note that there is an extremely small probability of more than 5super-grand prize wins. In a preferred embodiment, this would be handledby terminating the contract in the event that 5 super-grand prizes areawarded. This would be expected to happen less than once in 600 contractyears. Of course, if 10 similar lotteries are operating in parallel,this type of tail event would happen more frequently.

BRIEF SUMMARY OF THE INVENTION

The present invention provides several new ways to produce uncorrelatedreturns and to increase the risk-adjusted return of a portfolio, or moregenerally, any collection of assets and/or liabilities (“CoA/Ls”). Theseinclude:

-   -   Collateralized Gaming Obligations (“CGOs”);    -   FISCs;    -   TSFIs;    -   Virtual diversatives;    -   P2P FoFs; and    -   Programmable diversatives.

In embodiments, the present invention provides a method for using acomputer for managing financial instruments, wherein the computer isprogrammed to access one or more databases stored in computer readablememory operatively connected to the computer, containing assetinformation, liability information, counterparty information, metricinformation, and swap agreement information. The computer may be furtherprogrammed to receive first swap agreement information including firstcounterparty information identifying a plurality of counterparties tothe first swap agreement and first metric information comprising afuture cash flow that is at least partially determined by one or moreevents associated with playing one or more games. The computer may befurther programmed to perform the steps of executing said first swapagreement, updating the one or more databases with the firstcounterparty information and first metric information, determining afirst metric value for the first metric information, and calculatingfirst cashflows value to be paid and/or received according to thedetermined first metric value. The computer may be further programmed tosend the calculated first cashflows value to be exchanged and to updatethe one or more databases with the first metric value and the firstcashflows value.

DETAILED DESCRIPTION OF THE PREFERRED EMBODIMENTS

1. The above-described (and incorporated by reference) inventionprovides a means to increase the risk-adjusted expected return of one ormore portfolios by enabling one or more investors to purchase securities(or other financial instruments) a portion of whose cashflows areuncorrelated to financial market and/or economic variables.

2. Aside from its use to guarantee large prize payouts, the financialinstrument described above has a valuable characteristic from theinvestor standpoint: returns on this instrument are likely to have astable expected correlation to returns on ordinary financialinstruments. By “expected correlation” we mean a forecast of futurecorrelation of returns between two financial instruments, indexes, orbenchmarks. This forecast may be derived from historical correlationsand/or forecasting models.

3. Unstable correlations present great difficulties for investors and/orportfolio managers trying to construct an investment portfolio. Assetschosen for their apparent lack of correlation to each other in onemarket regime can suddenly become highly correlated (for example, duringa period of market turbulence) to the detriment of investors andportfolio managers.

4. One of the values of SCOREs is that they may be constructed tominimize (perhaps even eliminate) the effects of market regime change onreturns and correlations. For example, through margining and escrowarrangements, the game operator can be assured that the investor will beable to pay and that the payment is guaranteed through a financialinstitution with high credit quality.

5. Collateralized Gaming Obligations (CGOs). CGOs allow investor(s) tosell or otherwise transfer a part of the financial risk related to oneor more games (“game risk”) to other investor(s), whereby they mightonly have to pay up to a certain amount and/or a certain number ofprizes during a certain period, with the extra risk absorbed by one ormore third parties. Game risk may be divided into tranches, as ispresently done with collateralized debt obligations (“CDO”s).Traditional cash CDOs issue securities against debt securities held ascollateral and managed according to a strict set of rules known as anindenture. Synthetic CDOs replace the underlying securities with one ormore derivatives contracts (e.g. credit default swaps (CDS),standardized CDS indexes, and customized “bespoke” indexes).Analogously, game risk can be bundled into what we shall callCollateralized Gaming Obligations (“CGO”s). Investors in CGOs would beindirect purchasers of one or more varieties of gaming risk. SyntheticCGOs could be tranched to allocate risk/reward more efficiently whilepreserving the salient characteristic of gaming risk: its independencefrom market regime.

6. Financial Instruments with Specific Correlation Characteristics(“FISCs”). While pure gaming risk offers stable expected correlation,some investors may wish to have specifiable correlation that varies in apredictable manner. This may be accomplished by creating customderivative financial instruments with rules that constrain returns andrealized correlation among specified assets. For example, a financialinstrument may be composed of a SCOREs derivatives contract like the onedescribed in paragraph (3), with the added characteristic that it embedsan option on some other financial instrument of interest to theinvestor. This has the effect of transforming the expected correlationunder specific circumstances where such transformation if of value tothe investor.

7. In a preferred embodiment, financial instruments are defined,created, and sold with correlation characteristics (expected and/orrealized correlations) that vary as a function of a multiplicity ofmarket regimes. For example, an instrument is defined to have at or nearzero correlation to a given benchmark during market regime A and acorrelation at or near minus one to that same benchmark during marketregime B. This would be a 2-phase financial instrument with specificcorrelation characteristics (“FISC2”). More generally, an n-phasefinancial instrument with specific correlation characteristics isreferred to as “FISCn”. Such instruments, when implemented asderivatives (whether exchange-traded or over-the-counter) are examplesof what I call “diversatives.” Diversatives are derivatives that aredesigned to increase the value of one or more quantities correlated withthe expected risk-adjusted return of one or more portfolios and orCoA/Ls. Diversatives may preferably be structured as financial swaps. Inan alternative preferred embodiment, diversatives may be structured asswaptions. Other diversatives are described in U.S. Provisional PatentApplication 60/634,491, filed Dec. 9, 2004.

8. Say that the benchmark is a broad market index (equity, fixed income,commodity, or other type). A FISC2 instrument would specify means forperiodically (e.g., quarterly, monthly, daily, hourly) determining thestate of the market (either regime A or regime B); based on saiddetermination the terms of the instrument would be used to calculatebidirectional cashflows and/or accruals between one or more holders ofthe instrument and one or more issuers and/or other counterparties(e.g., underwriters).

9. FISC2 diversatives may be used to hedge against a risk that currentlycannot be hedged against: phase locking risk. Phase locking refers tothe sudden shift from mostly uncorrelated to the (nearly) fullcorrelation exhibited by many financial instruments and hedge fundsduring periods of market crisis. For a discussion of phase locking andconditional correlation, see “Systemic Risk and Hedge Funds”, a paper byNicholas Chan, Mila Getmansky, Shane Haas, and Andrew Lo, dated Feb. 22,2005, prepared for the NBER conference on the Risks to FinancialInstitutions.

10. For example, a FISC2 diversative could combine a plain vanillaSCOREs contract with an embedded option linked to a change in marketregime. In a preferred embodiment, the option would entitle its holderto receive cashflows equivalent to selling one or more financialinstruments at a price associated with the previous market regime (e.g.,last price before change of regime, highest price in preceding n months,average price of preceding n months, etc.)

11. In an alternative preferred embodiment, the change in market regimecould convert the SCOREs random payout features into an option like theone described above, suspending the non-correlated (SCOREs) portion ofthe financial instrument and strengthening its negative correlationduring the market crisis.

12. A FISC_(n) diversative, with n>2, may preferably re-convert into anon-correlated type instrument after a second change in market regime.The number of flips between market regimes need not be predefined;rather, the term of the FISCn diversative may be set as a number ofdays, months, or years, or as a perpetual instrument (like a stock orBritish consol bond), and definitions of market regimes may beestablished such that the diversative may change as many times as themarket regime shifts during the term of the diversative.

13. In general, investors can use FISCs to create derivative financialinstruments with one or more of the following characteristics:

a. Stable expected correlation

b. Randomly varying expected correlation

c. Algorithmically determined expected correlation

d. Stable realized correlation

e. Randomly varying realized correlation

f. Algorithmically determined realized correlation

g. Zero expected correlation

h. Zero realized correlation

14. Time-shifted financial instruments (“TSFI”s). TSFIs increaserisk-adjusted returns of portfolios by exchanging a current periodreturn for

a. Past actual returns over one or more time periods

b. Future forecast returns over one or more time periods

c. Future forecast returns that are adjusted as a function of actualrealized returns

d. Randomly generated mixtures of at least two of a,b,c

e. Algorithmically determined mixtures of at least two of a,b,c

An investor could agree to forego a first portion of his current yearreturn on an index or other reference portfolio, in exchange forreceiving a return equal to a second portion of a mutually agreed uponforecast return for the following year, to be adjusted in year two asactual monthly returns are realized. He might also agree to accept athird portion of current year returns next year in payment for giving upa fourth portion of next year's actual returns. For example, let thereference portfolio by the S&P 500 Index, and assume that all portionsare halves. Assume further that current year returns turn out to be 20%(at end of current year=year 1) and that next year (year 2) returns areforecast to be 10% but turn out to be 8%. Then the investor who entersinto this arrangement with a counterparty (whose characteristics arediscussed below) receives (20%+10%)/2=15% for the first year, and(20%+8%−2%)/2=13% for the second year.

Absent this transaction, he would have received 20% and 8%, which(neglecting transaction costs and the effects of compounding) is thesame total return with a significantly higher variance.

Three questions spring to mind: who could and would want to be acounterparty to this transaction, what would transaction costs be, andwhat would be the effect of compounding on the economics of such “timeswaps”?

The counterparty is the key. If there are natural counterparties to suchtransactions, then transaction costs are likely to be low. Compoundingeffects, while potentially large for volatile portfolios, are likely tobalance out sometimes working to the benefit of the swapper, sometimesto his detriment. But is there a natural counterparty?

In fact there are many. Other investors, looking to devolatilise theirportfolios, may contract with the first investor directly. Financialintermediaries may make a “book of time trades”, getting compensatingfor making a market and for reducing overall market risk.

Explanatory note: TSFIs are distinct from futures contracts and forwardcontracts in at least the following ways:

-   -   They are exchanging returns, not buying or selling an underlying        commodity.    -   They may reference historical returns and have no connection to        future price levels    -   They may blend historical, current, forecast future, and actual        future returns in a myriad of ways.

15. Virtual diversatives and Peer to peer fund of funds (“P2P FoFs”).Diversatives provide alternative mechanisms to increase therisk-adjusted expected return, with or without linkage to gaming eventsper se, though the mechanisms may be modeled in a game-theoreticframework. (See Theory of Games and Economic Behavior, von Neumann andMorgenstern, 1944.) In what follows, methods and systems are disclosedthrough which one or more investors may swap cashflows defined by one ormore metrics associated with one or more portfolios in order to increasethe value of one or more quantities correlated with the risk-adjustedexpected return of said portfolios. Said swaps may preferably begoverned by documents modeled after existing derivative contracts suchas are standardized by the International Swaps & Derivatives Association(“ISDA”).

16. Definition: A financial swap is an exchange of payments betweencounterparties whose timing and other conditions are governed by a legalagreement called a “swap agreement”. [See Swap Literacy by ElizabethUngar, Bloomberg Press, 1996.]

17. Additional definition: A swaption is an option to enter into swap.Payment of an option premium gives the buyer the right, but not theobligation, to enter into a specified swap agreement with the seller ofthe swaption.

18. As is known in the art, when assets that are uncorrelated to a givenportfolio are added to said portfolio, said assets having an expectedreturn greater than or equal to a first threshold value, the resultantportfolio shows an increase in its risk-adjusted expected return. Saidincrease also results when uncorrelated assets with expected returngreater than or equal to a second threshold value are acquired andsubstitute for more highly correlated assets whose expected return isnot greater than a third threshold value. For these reasons, fundmanagers sometimes make investments in other funds whose correlationwith their own fund or funds is sufficiently low, and whose expectedreturns are sufficiently high, to benefit from these effects. Indeed,funds of funds (“FoF”), a large and growing segment of the fundmanagement business, are designed for investing in other funds. We willrefer to these effects as “The Principle of Diversativity”,distinguishing between the case where assets are added (“additivediversativity”) and the case where assets are substituted(“substitutionary diversativity”).

19. The Principle of Diversativity applies whether the underlying assetsare primarily publicly traded securities, derivatives, securities ofprivate companies, or any collection of assets and/or liabilities whoseexpected return and correlation to said portfolios may be estimated withsufficient accuracy.

20. Definition. A correlation manager (“CorMan”, plural “Cormen”) is anymanager responsible for managing a Collection of Assets and/orLiabilities (“CoA/Ls”), who may use The Principle of Diversativity,implicity or explicitly, knowingly or unknowingly, to increase theexpected risk-adjusted return of one or more CoA/Ls. Examples of Cormeninclude hedge fund managers, fund of hedge fund managers, mutual fundmanagers, other fund of fund managers, venture capital fund managers,private equity fund managers, separate account managers, commodity fundmanagers, corporate treasurers, other treasurers, and people responsiblefor managing at least a portion of one or more portfolios of assetsand/or liabilities.

21. In contrast to current methods, the invention disclosed hereinoffers a more flexible mechanism for investors and Cormen of one or moreinvestment portfolios and/or other CoA/Ls to increase the expectedrisk-adjusted return of said portfolios and/or other CoA/Ls. Theinvention improves upon existing financial swaps by defining a new groupof derivative financial instruments that involve swap agreementscontaining metrics relating to the risk and return characteristics ofone or more portfolios and/or CoA/Ls.

22. In a preferred embodiment, two Cormen can trade a diversativedefined by an expected return metric. For example, Cormen A and B mightagree to swap 50% of the expected returns of their respective portfoliosfor a certain time period (the swap's “tenor”) and on certain dates(“swap payment dates”). Expected returns would be defined in the swapagreement. In a preferred embodiment, said definition would benegotiated by the Cormen. In an alternative preferred embodiment, saiddefinition would be the responsibility of a neutral third party.

23. In an alternative preferred embodiment, two or more Cormenresponsible for different subportfolios within the same CoA/L can tradea diversative as in the example above. This may preferably be done withinternal swap rules similar to conventional ISDA type agreements, butcarried out within the context of a single legal entity. These rules maybe preferably linked to agreements (e.g., with investors and/or serviceproviders) to make the rules legally binding. We call this type ofintra-CoA/L diversative a “virtual diversative”. Despite its name, itstill has the real effect of increasing risk-adjusted expected returnfor the CoA/L in which it resides.

24. In a preferred embodiment, the definition of expected return couldbe expressed as an absolute return. In an alternative preferredembodiment, the definition could be expressed as a relative return,defined against a benchmark or other objectively verifiable phenomenonthat might at defined intervals be used to programmatically recalculatethe value of one or more metrics and the value of one or more quantitiescorrelated with risk-adjusted expected return.

25. In another alternative preferred embodiment, three or more fundmanagers could swap expected returns amongst themselves, usingdiversatives to create what could be thought of as peer to peer funds offunds (“P2P FoFs”). P2P FoFs differ from ordinary FoFs in that they aremanaged by the actual fund managers, each of whom knows at least theirown fund better than a traditional FoF manager. They also differ fromsingle manager multi-strategy funds in that they are not limited to thefunds of a single investment manager (and/or its affiliates). Finally,they differ from existing investments by (FoF and/or non-FoF) fundmanagers in third party funds in at least the following ways:

a. they are not direct investments in the funds themselves, rather theyare swaps of cashflows related to the performance of said funds.

b. Being swaps, they are governed by swap agreements that may preferablybe standardized, and may be assignable or tradeable.

c. Unlike so-called “fee swaps”, they preserve the alignment of interestof the fund managers and fund investors.

d. By eliminating the need to invest in the funds themselves, a layer ofcost, fees, complexity, and operational risk is eliminated or at leastreduced.

e. The metrics used to define these swaps may be customized to includenegotiation methods, third party valuation methods, adjustments forrisk, adjustments for ex post versus ex ante measurements, adjustmentsfor other exogenous events.

26. For example, a multi-strategy fund wishing to add a new strategywithout having to acquire all of the operational expertise associatedwith that strategy may acquire exposure to that strategy quickly and atsignificantly lower cost by entering into a diversative swap with a fundalready successfully deploying that strategy. If the latter fund desiresexposure one of the former fund's strategies, then each may achievehighly cost-effective increases to their respective risk-adjustedreturns, delivering a competitive advantage to both funds againstsimilar funds who do not enter into a similar swap agreement.

27. Similarly, a corporation desiring to add exposure to a particularline of business may enter into a diversative swap with a corporation orother entity already engaged in that business. Swap terms may referencethe performance of one or more operating entities, business units,subsidiaries, or the equivalent. Said swaps may be highly effective,customizable means to achieve a desired exposure to particularbusinesses without the time, cost, and risk associated with mergers andacquisitions.

28. Programmable diversatives. U.S. nonprovisional patent applicationSer. No. 10/733,482, filed Dec. 11, 2003, describes financialinstruments embodied in or represented by computer programs. In analternative preferred embodiment, diversatives may be embodied orrepresented by said computer programs. Said programs may be web agents,that travel over the internet interacting with other similar programs.U.S. nonprovisional patent application Ser. No. 10/733,482 disclosesmethods and systems for creating and managing programmable financialinstruments. Programmable diversatives may be used to facilitatereal-time risk management of funds.

29. A preferred method for creating diversatives structured as financialswaps or swaptions comprises:

a. selection of one or more counterparties;

b. selection of one or more portfolios or other CoA/Ls;

c. selection of one or more metrics (see examples below);

d. execution of a swap (and/or swaption) agreement using said metricswith said CoA/Ls and said counterparties;

e. determination of the value of said metrics;

f. determination of the value of one or more quantities correlated withthe risk-adjusted expected return of said CoA/Ls;

g. calculation of cashflows to be paid and received according to thevalues of the metric(s) and the terms of the agreement;

h. exchange of cashflows according to the terms of the agreement; and

i. assignment, partial assignment, or unwinding of the agreement.

30. Metrics for Diversative Swap Agreements may preferably includecalculations involving:

a. Expected return

b. Ex Ante Alpha

c. Ex Post Alpha

d. Ex Ante Beta

e. Ex Post Beta

f. Historical Correlation Coefficient

g. Implied Correlation

h. Historical Volatility

i. Implied Volatility

j. Historical Skewness of Returns

k. Historical Kurtosis of Returns

l. Forecast Skewness of Returns

m. Forecast Kurtosis of Returns

31. In a preferred embodiment, one or more databases containinginformation about assets, liabilities, and correlations may be searchedby web agents and/or other programs to identify potential diversativetrades, notifying potential counterparties (preferably in real-time)about the existence of beneficial trades, and facilitating said trades,preferably through real-time electronic means.

32. While the invention has been described in conjunction with specificembodiments, it is evident that numerous alternatives, modifications,and variations will be apparent to those skilled in the art in light ofthe foregoing description.

What is claimed is:
 1. A method for using a computer for managingfinancial instruments, wherein the computer is programmed to perform thefollowing operations: (a) accessing, using the computer, one or moredatabases stored in computer readable memory operatively connected tothe computer, containing: (1) asset information, (2) liabilityinformation, (3) counterparty information, (4) metric information, and(5) swap agreement information; (b) receiving, using the computer, firstswap agreement information including: (1) first counterparty informationidentifying a plurality of counterparties to the first swap agreement,and (2) first metric information comprising a future cash flow that isat least partially determined by one or more events associated withplaying one or more games; (c) executing, using the computer, said firstswap agreement; (d) updating, using the computer, the one or moredatabases with the first counterparty information and first metricinformation; (e) determining, using the computer, a first metric valuefor the first metric information; (f) calculating, using the computer,first cashflows value to be paid and/or received according to thedetermined first metric value; (g) sending, using the computer, thecalculated first cashflows value to be exchanged; and (h) updating theone or more databases, with the first metric value and the firstcashflows value.
 2. A computer programmed to perform the followingoperations: (a) accessing, using the computer, one or more databasesstored in computer readable memory operatively connected to thecomputer, containing: (1) asset information, (2) liability information,(3) counterparty information, (4) metric information, and (5) swapagreement information; (b) receiving, using the computer, first swapagreement information including: (1) first counterparty informationidentifying a plurality of counterparties to the first swap agreement,and (2) first metric information comprising a future cash flow that isat least partially determined by one or more events associated withplaying one or more games; (c) executing, using the computer, said firstswap agreement; (d) updating, using the computer, the one or moredatabases with the first counterparty information and first metricinformation; (e) determining, using the computer, a first metric valuefor the first metric information; (f) calculating, using the computer,first cashflows value to be paid and/or received according to thedetermined first metric value; (g) sending, using the computer, thecalculated first cashflows value to be exchanged; and (h) updating theone or more databases, with the first metric value and the firstcashflows value.